The tax-to-GDP ratio is an economic metric used to measure the total tax amount earned by a country relative to its economy, as measured through the Gross Domestic Product (GDP). Taxation is one of a country's most fundamental policies, where almost all earnings are taxed to ensure the government has funds for the nation’s development activities. However, a country's economic performance heavily depends on how the government utilises the funds earned through taxes.
As the tax-to-GDP ratio is an ideal metric to grasp the government’s utilisation of tax earnings, it becomes important to understand what is tax to GDP ratio. This blog will help you understand the tax-to-GDP meaning and how it is used and calculated.
What is the tax-to-GDP ratio?
The tax-to-GDP ratio serves as a key indicator of a nation's fiscal health, quantifying the proportion of economic output captured through taxation. By comparing this ratio across different countries, policymakers can assess the relative efficiency of taxation systems in generating revenue to fund public services and infrastructure. Generally, developed economies exhibit higher tax-to-GDP ratios than developing nations, reflecting factors such as more extensive social welfare programs, robust regulatory frameworks, and greater economic complexity.
The direct tax-to-GDP ratio in India has exhibited a positive trajectory, culminating in a notable increase to 6.6% in the fiscal year 2023-24. This marks a significant elevation from the preceding year's ratio of 6.1%, establishing the highest point observed in the last fifteen years. Furthermore, projections indicate a sustained upward trend, with the ratio anticipated to reach approximately 6.7% in the forthcoming fiscal year.
How does the tax-to-GDP ratio work with examples?
The tax-to-GDP ratio measures the total tax amount earned by the government against its annual GDP. As the ratio is calculated every year after the completion of the tax cycle and GDP calculations, it gives the government and citizens a benchmark against which they can compare tax revenues yearly. Analysing the tax-to-GDP ratio provides insight into a government's tax earnings and its ability to avoid borrowing money for the country's developmental activities. The higher the tax-to-GDP ratio, the higher the ability of a country to spend more on improving education, health, infrastructure, etc.
For example, India’s tax-to-GDP ratio increased to 11.6% this year from 11.2% last year. This means India's total tax earnings have increased in the last year and are now 11.6 % of the total GDP.
The tax-to-GDP ratio uses two economic parameters: Annual tax revenue and the Gross Domestic Product (GDP). The tax revenue includes the total amount of tax earned by the government through income tax, sales tax, estate tax, property tax, etc. On the other hand, GDP is the total value of all the goods and services produced in the country during a financial year.
The government uses this tax revenue for development activities. Tax revenue and GDP are considered to be correlated to each other. This means there is a chain reaction where the government uses the tax revenue to improve the economy, which results in higher employment or earning potential. With higher earnings, the tax revenue increases further, with the government having more to spend next year.
Formula for tax-to-GDP ratio
Here is the tax-to-GDP ratio formula:
Tax-to-GDP ratio = (Total annual tax revenue of a country/Gross Domestic Product) x 100 |
Example of Tax to GDP Ratio
Having defined the tax-to-GDP ratio, we can now examine a concrete example to illustrate its calculation.
Please consider the fiscal data for countries X and Y as presented below:
Particulars |
Country X |
Country Y |
Tax revenue |
Rs. 2.50 lakh crore |
Rs. 4 lakh crore |
GDP |
Rs. 15 lakh crore |
Rs. 20 lakh crore |
For Country X, the tax-to-GDP ratio is calculated as follows:
Rs. 2.50 lakh crore/Rs. 15 lakh crore = 16.67%
Similarly, for Country Y, the tax-to-GDP ratio is:
Rs. 4 lakh crore / Rs. 20 lakh crore = 20%
A comparative analysis of these tax-to-GDP ratios reveals that Country Y exhibits a higher degree of economic development in comparison to Country X.
Importance of tax-to-GDP ratio
The tax-to-GDP ratio calculates how much tax revenue has been collected against the GDP in percentage terms. Hence, it is an important factor in understanding a country’s economic and financial health. The ratio measures the government’s ability to make resources available to the citizens and finance its developmental activities without borrowing excessive funds. A higher tax-to-GDP ratio indicates that the government can generate substantial tax revenue relative to the size of its economy.
The tax-to-GDP ratio also plays an important role in economic policy and planning for the government. Using the results of the ratio, the government can assess the current effectiveness of its tax policies and ensure that there are improved tax reforms in the future. For example, if the ratio is low, the government can broaden the tax base or improve its tax collection policies. On the other hand, if the ratio is excessively high, it may indicate that the policies are creating an overtaxed economy and may lead to lower investment and economic growth.
Furthermore, the tax-to-GDP ratio also provides a benchmark for comparing different countries and their economic performance. For example, developed countries often have a higher tax-to-GDP ratio than developing or underdeveloped countries. Countries with a lower tax-to-GDP ratio can compare their policies with those of developed countries and identify areas where they can improve to provide a better standard of living to their citizens.
Uses of tax-to-GDP ratio
Here are the uses of the tax-to-GDP ratio:
1. Government’s revenue efficiency
The tax-to-GDP ratio provides insights about a government’s revenue efficiency through its tax collection system. You can compare tax revenue with total GDP to determine how well the government is using tax revenue for economic development.
2. Policymaking
The government analyses the tax-to-GDP ratio to improve or create policies. A low tax-to-GDP ratio may indicate that the policies are inefficient and that tax collection needs to be improved. On the other hand, a higher-than-normal tax-to-GDP ratio might indicate that the government needs to lower the tax burden on its citizens.
3. Economic development
Every government uses the tax revenue for developmental activities or activities that can create a positive economic performance. Comparing the tax-to-GDP ratio of a year to the previous years can help provide insights as to how the government is using the tax revenue against the overall GDP. If the ratio is decreasing year by year, it may indicate that the government is failing in economic development and tax administration.
4. Social equality
The tax-to-GDP ratio can also be used to address social equality issues. By analysing the composition of tax revenue and its impact on different income groups, policymakers can design tax systems that are fair and equal. For example, India uses a progressive taxation system, where a higher tax rate is applicable to higher earnings.
Why does the tax-to-GDP ratio matter?
Here is why tax-to-GDP ratio matters:
- The ratio indicates the country's tax revenue against its GDP, becoming an indicator of the government’s earnings, which it can use for developmental activities.
- The government uses the ratio to review and improve its policies. If the ratio is lower or higher than normal, the government uses the results to improve its taxation policies.
- The ratio provides a measure for comparing two countries based on their tax revenues and the government’s ability to avoid excessive borrowings. A country with a higher tax-to-GDP ratio is considered economically stronger.
- A balanced tax-to-GDP ratio indicates that the country is economically stable and has a higher growth potential. It shows that the government has sufficient resources to manage the economy and ensure its positive performance.
How to improve the tax-to-GDP ratio?
Every country that measures the tax-to-GDP ratio constantly tries to ensure its tax-to-GDP ratio is higher than last year. However, there have been instances in which a country has witnessed a lower tax-to-GDP ratio than the previous year, negatively affecting economic performance.
One of the best ways for a government to improve its tax-to-GDP ratio is to increase tax collection. In almost every country, individuals and entities avoid paying taxes even when they are legally liable. A government must identify such individuals and entities and ensure that every earning individual pays applicable taxes. As far as India is concerned, implementing the Direct Tax Code (DTC) can immensely help. DTC aims to simplify the structure of direct taxes in India to ensure improved tax compliance.
Furthermore, the Indian government can review the GST structure and ensure it is effective and rationalised. The recent GST Council meeting has also helped in this matter as the panel took several decisions to change the applicable GST rates for improvement.
What is a good tax-to-GDP ratio?
Most countries aim to have a tax-to-GDP ratio equal to or higher than 15%. Such a score indicates that the country’s economic condition is good and that it has enough funds to spend on developmental activities without having to borrow funds. India is also on the path of increasing its tax-to-GDP ratio to 15%, as the ratio has been steadily rising every year.
Factors affecting the Tax-to-GDP Ratio
The tax-to-GDP ratio in India is influenced by a complex interplay of macroeconomic factors and policy choices. Key determinants include:
1. Economic policies
The design and implementation of tax policies, including rates, exemptions, deductions, and incentives, significantly impact the total tax revenue collected.
2. Economic growth
Periods of robust economic expansion typically correlate with increased income and corporate profits, leading to higher tax revenues.
3. Tax administration
The efficiency of tax collection systems and efforts to combat tax evasion directly influence the overall tax-to-GDP ratio.
4. Sectoral composition
Economies with a predominance of high-tax sectors, such as manufacturing or services, tend to exhibit higher tax-to-GDP ratios compared to those reliant on low-tax sectors, such as agriculture or primary industries.
5. Informal economy
The size and extent of the informal sector can significantly impact tax revenue collection. Unrecorded economic activities that evade taxation contribute to a lower tax-to-GDP ratio.
How does the Tax to GDP Ratio affect the economy?
The tax-to-GDP ratio exerts a significant influence on the economy. Key areas affected include:
- Public services: Higher ratios enable governments to allocate greater resources to public services and infrastructure development, enhancing the overall quality of life.
- Fiscal health: A robust tax-to-GDP ratio indicates a government's ability to fulfill its financial obligations without excessive reliance on borrowing, ensuring long-term economic stability.
- Income distribution: Progressive tax systems that contribute to higher ratios can promote greater equity in income distribution when the collected revenue is effectively utilised to support social welfare programs.
- Investment: The impact of tax-to-GDP ratios on investment is nuanced. While high ratios with elevated tax rates may deter investment, moderate ratios coupled with consistent tax policies can attract investors and foster economic growth.
Decrease in tax to GDP ratio of a country indicates
A decline in a nation's tax-to-GDP ratio can be indicative of two potential economic conditions. Firstly, it may suggest a decrease in government tax revenue due to policy changes that have reduced the tax burden, a narrower tax base, or a slowdown in economic activity. Alternatively, it could signal a period of rapid economic growth where GDP has outpaced tax revenue, posing a challenge to governments reliant on taxes for funding public services and infrastructure.
Key takeaways
- The tax-to-GDP ratio is an economic indicator that compares tax revenue to GDP.
- It reflects a country's economic health and tax policy effectiveness.
- The formula is calculated as: (Total tax revenue / GDP) x 100.
- India's current ratio is 11.6%, up from 11.2% last year and projected to reach 11.7% next year.
- The government uses this data to refine taxation strategies.
Conclusion
The tax-to-GDP ratio is an economic metric that showcases how much a government has earned through tax against the size of its economy, which is presented through its GDP. This ratio is immensely important for citizens to grasp the country's economic performance and for the government to review and improve its taxation policies. A higher tax-to-GDP ratio indicates that the government has high funds to spend on socio-economic development activities such as education and healthcare without borrowing. Now that you know what is the tax-to-GDP ratio, you can better understand India’s economic performance through its tax revenues.
